Investing for income: The name is bond - corporate bond

PLUMMETING INTEREST rates put a smile on the face of anyone with a variable rate mortgage. But if you want an income from your investments, the news could not be worse. Returns on building society and bank deposits are shrinking, with rates on many long-term investments faring no better.

"The fact is that yields are falling on everything, whether it's postal accounts or gilts," says Andrew Jones of independent financial advisers The David Aaron Partnership.

Corporate bonds are basically IOUs issued by companies. People who buy corporate bonds are lending to a business which pays them a fixed rate of interest, and usually promises to repay the capital back on a fixed date. They are like gilts, or UK Government bonds, but carry more risk, because the government is considered more creditworthy than most companies. So corporate bonds pay more interest than deposits, gilts or other more solid fixed-rate investments.

Once issued, the capital value of any bond fluctuates, depending on the financial health of the issuer and prevailing interest rates. This gives funds holding the bonds some scope for capital growth.

Corporate bond funds take the form of either unit trusts or open-ended investment companies (OEICs). Like equity-based funds, they can be held tax-free in Personal Equity Plans (PEPs). But from this April, corporate bond funds will have an advantage over share funds.

The 20 per cent tax credit which PEP investors can reclaim on their share dividends will be cut to 10 per cent after 5 April, and disappear altogether five years later. But corporate bonds will not be affected as an income is paid as interest rather than dividends.

"A lot of big players in the corporate bond market have focused on high- yield bond funds - that is a relatively new feature of the corporate bond fund market," says Jason Hollands of brokers Best Investment. "We are seeing more demand for income, and investors have been cautious about equities because of the volatility," he says.

Fund managers Perpetual, Schroders, and Fidelity have all recently launched higher yielding corporate bond funds in the retail market, following the success story of M&G. M&G started its high-yield corporate bond fund last September, marketing it alongside its existing corporate bond fund. The high-yield PEP has a redemption yield of 7.8 per cent, compared with 5 per cent for its other corporate bond PEP.

In order to achieve that, M&G holds most of the fund's assets in what are known as sub-investment grade bonds - infamously known in the Eighties as junk bonds.

Ratings agency Standard & Poor's assesses the creditworthiness of a whole host of bond issuers. The ratings go from AAA+, for the most financially solid concern, right down to D for default. A bond from an issuer with a rating above BBB- is considered investment grade, but below this, sub- investment grade.

"This is where the incidence or likelihood of default increases markedly," says Tony Assender of S&P. A number of well-established companies issue sub-investment grade bonds, including IPC Magazines, Orange Telecom and BSkyB.

Investing in sub-investment grade bonds individually would be very risky, but investing in a fund holding them is much less so. The risk is spread, and fund managers believe the effectiveness of their research cuts the risk still further.

But the corporate bond market in the UK is still very small compared to the equities market, and this could limit the scope for funds. M&G says it is glad it got in early in the high-yield end of the market.

"We were able to pick up some real bargains, and we have a portfolio that not everyone will be able to get," says Tessa Murray of M&G. For example, the fund invested early on in bonds issued by betting shop business William Hill, which has subsequently been floated on the stock market.

Andrew Jones describes corporate bond funds as the first step away from deposits in terms of risk. But that risk should not be ignored, particularly with high-yield funds.

Because of the increased risk, M&G says its high-yield fund should not be seen simply as a corporate bond fund with a high yield. "We look at it as we would an equity fund," says Ms Murray. Investors should see it as a total return fund rather than an income-producing fund.

Andrew Jones and Jason Hollands recommend Fidelity in the high-risk corporate bond fund market, because of its vast investment research resources - important when assessing the prospects for sub-investment grade bonds.

Of the mainstream corporate bond funds, Mr Jones suggests Aberdeen Prolific and the well established CGU Monthly Income Plus. Mr Hollands prefers Legal & General for its low charging structure.

Best Investment Brokers, 0171 321 0100; The David Aaron Partnership, 01908 281544 (corporate bond PEP guide; available pounds 2 to cover p&p); M&G, 0800 390 390 (M&G offers a guide to fixed interest investment); Aberdeen Prolific, 0345 886666; Legal & General, 0500 116622; CGU, 0845 6072439